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PCAOB proposes sweeping changes to the auditor’s reporting model

The PCAOB on Tuesday proposed sweeping changes to the auditor’s
reporting model for U.S. public companies that would include a
requirement for auditors to identify and describe “critical audit matters.”

In addition, new standards and related amendments proposed
by the PCAOB would require:

A statement of auditor independence. This would
explain that the auditor is a public accounting firm registered with
the PCAOB and is required to be independent with respect to the
company.

Tenure disclosure. The audit firm would disclose
the year it began serving as a company’s auditor.

Other information explanation. The auditor would be
required to describe the procedures and evaluation the firm
performed on other types of information included in the annual
report outside the financial statements.

Language enhancements. These would change existing
language in the auditor’s report related to the auditor’s
responsibilities for fraud and notes to the financial statements.

The board unanimously approved exposing the proposal for public
comment, although board member Steve Harris expressed disappointment
that the proposal would not provide as much useful information for
investors as he had hoped. Stakeholders can comment on the proposal by
Dec. 11 at the PCAOB’s website.

PCAOB Chairman James Doty said the proposal marks “a watershed
moment” for auditing in the United States.

“The proposed standards … would make the audit report more relevant
to investors by establishing criteria and a framework providing deeper
insights from the audit, based on information the auditor already
knows from the audit,” Doty said during an open meeting Tuesday.

What are “critical audit matters”?

The proposal is designed to change how auditors report without
significantly changing the procedures auditors perform.

A key component of the proposal would be the requirement to identify
and report on critical audit matters, which are defined as matters
addressed during the audit that:

Involved the most difficult, subjective, or complex auditor
judgments;

Posed the most difficulty to the auditor in obtaining sufficient
appropriate evidence; or

Posed the most difficulty to the auditor in forming an opinion on
the financial statements.

When critical audit matters are determined, auditors would be
required in their report to:

Identify the critical audit matter.

Describe the considerations or reasons that the matter was
identified as critical.

Refer to the relevant financial statement accounts and disclosures
that relate to the critical audit matter, when applicable.

The communication is not intended to alter the auditor’s opinion
on the financial statements as a whole. If the auditor determines
there are no critical audit matters to communicate, the auditor would
state that conclusion in the auditor’s report.

The proposed auditor reporting standard, The Auditor’s Report on
an Audit of Financial Statements When the Auditor Expresses an
Unqualified Opinion, would supersede portions of AU Sec. 508,
Reports on Audited Financial Statements.

Evaluating “other information”

The proposed “other information” standard describes new procedures
the auditor would be required to perform. The auditor would be
required to evaluate information that is included in an annual report
filed in Form 10-K, but is outside the audited financial statements.
Selected financial data and management’s discussion and analysis would
be among the items the auditor would be required to evaluate.

In addition, the proposed standard describes procedures the auditor
is required to perform after identifying a material inconsistency or
material misstatement between the other information and the audited
financial statements.

When issuing the auditor’s report, the auditor would include, in a
separate section, specific statements regarding the auditor’s
responsibilities for the other information. Regardless of whether an
inconsistency or misstatement of fact is discovered, the auditor would
report the results of that evaluation, PCAOB Associate Chief Auditor
Jessica Watts said during Tuesday’s meeting.

Although AU Sec. 550 requires auditors to read and consider other
information, the new standard proposes an incremental change because
it would require auditors to read, evaluate, and perform specific
procedures, PCAOB Chief Auditor Martin Baumann said during the open meeting.

Few changes in 70 years

Audit reports in the United States have not undergone significant
revision since the 1940s, Baumann said. Investors have expressed
interest in a report that does more than give a pass/fail opinion from
the auditor on whether the financial statements are presented fairly,
Baumann said.

The PCAOB has conducted extensive outreach in developing a proposal
that will have a significant impact.

“I believe we are substantially improving the auditor’s report in
ways that will make it much more relevant and useful for investors and
other users of the financial statements,” Baumann said.

The proposal is similar to an auditor’s reporting model proposal exposed for
public comment last month by the International Auditing and Assurance
Standards Board, PCAOB member Jay Hanson said, although the PCAOB
arrived at its conclusions independently.

Hanson said the board has devoted enormous resources to the project
in hopes of giving investors more information than the current
pass/fail model provides.

“It’s not something taken on lightly when the pass/fail model has
been successful in the past,” Hanson said in a telephone interview.
“Nobody is saying, ‘Get rid of the pass/fail model.’ It’s just, what
more can we learn from the auditors about the audit that might be
helpful to investors?”

Center for Audit Quality (CAQ) Executive Director Cindy Fornelli
expressed support for responsible change to the auditor’s report.
Fornelli said in a statement that she is encouraged that the PCAOB
acknowledged concerns with an auditor’s “discussion and analysis”
approach that had been considered.

The CAQ, which is affiliated with the AICPA, believes management,
not auditors, should be the original source of information about an
entity, Fornelli said. She also commented on the proposed auditor
tenure requirement.

“As noted by several board members at today’s open meeting, there is
no demonstrated correlation between auditor tenure and audit quality,”
Fornelli said.

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